S Corp Disadvantages: Everything You Need to Know

There are several S Corp disadvantages that you need to consider before electing this tax status with the IRS.4 min read

There are several S Corp disadvantages that you need to consider before electing this tax status with the IRS.

What Is an S Corporation?

The corporate structure you choose will depend on the sort of business that you are running, as well as your shareholder's long-term and short-term goals. For federal tax purposes, S corporations are treated as pass-through entities. You can receive this tax treatment after electing S corporation status with the IRS. With an S corporation, just like with other corporations, you will be required to file Articles of Incorporation with your Secretary of State.

If you form an S corporation, corporate losses and profits will be allocated to shareholders. This avoids the double taxation that applies to other corporations. S corporation shareholders will be taxed individually on the income that is passed to them by the company. Business owners prefer S corporations because of their single taxation and their limited liability protections.

S Corporation Disadvantages

In certain circumstances, the advantages of an S corporation can become disadvantages depending on the needs of your business. For instance, S corporations are much less flexible than limited liability companies in terms of operations.

The biggest disadvantage of an S corporation is that the incorporation process can cost you time and money. Incorporating an S corporation requires:

Some states may also require you to pay ongoing fees such as a franchise tax or annual report, adding to your expenses. Even though these fees are deductible, and they aren't that expensive, they don't apply to other business structures.

Corporate Formalities

Another drawback of an S corporation is that they are required to observe corporate formalities. For example, S corporations are required to file a large number of official documents, which can include corporate minutes. S corporations must also hold shareholder meetings on a regular basis and need to pay all government fees.

Loss of S Corporation Status

Due to the complicated requirements or notification, stock ownership, election, and consent, it's possible for a corporation to lose its S corporation tax states. Losing S corporation status is usually fixed very easily, and happens rarely, but it is still a drawback of this corporate structure that needs to be considered.

Calendar Restrictions

S corporations must use a calendar year instead of a fiscal year unless they can prove a good reason for doing otherwise.

Stock Ownership

There are also restrictions on stock ownership for S corporations. For starters, there is only one class of stock. In effect, this means that S corporations cannot have different investor classes. S corporations are also limited to 100 or fewer stockholders, and there can be no foreign ownership of stocks. Stock ownership by entities such as trusts is also restricted.

IRS Scrutiny

Because both salaries and dividends can be distributed to S corporation shareholders, the IRS pays close attention to payments to make sure they are being characterized truthfully. It is possible that the IRS will re-characterize wages, choosing to treat them as dividends instead. This will result in your corporation losing a compensation paid deducted. The IRS may also decide to characterize dividends as wages, which may mean your corporation will be liable for the employment tax.

Lack of Flexibility

In terms of distributing losses and income, S corporations are considerably less flexible than other business structures. Because S corporations are limited to one class of stock, it can be difficult to distribute income and losses to a specific shareholder. In an S corporation, distribution is determined by stock ownership. This differs from LLCs and partnerships, where an operating agreement can be used to allocate losses and income.

The advantages you can receive from electing S corporation status more than makeup for any potential disadvantages. For instance, if you need to discontinue your business or are interested in transferring ownership, structuring your business as an S corporation makes these processes much easier. You generally won't receive these benefits when choosing a sole proprietorship or general partnership as your business structure.

S corporations also provide liability protections to their shareholders. These limited liability protections are also available to C corporations and LLCs. Unless there is a personal guarantee in place, S corporations shareholders cannot be held liable for the company's debts. This means that when a creditor sues the company for an unpaid debt, they cannot pursue the personal assets of shareholders, including:

Bank accounts

Houses

Cars

With a partnership or sole proprietorship, the owners of a business are personally liable for any and all company debts, as the owner and their company are legally inseparable.

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